Re-Fi Necessity: Crunching the Numbers

These days about three out of four mortgage applications involve a refinancing rather than a home purchase, which is understandable given today’s bargain rates and the risky housing market. But how many borrowers who expect to cut their homeownership expenses will increase them instead?

The culprit: a fixation on monthly payments without considering how, after a few years, a new mortgage can leave the borrower owing more than if the old loan had been kept.

Homeowners considering refinancing typically focus on two numbers — potential savings in monthly payments and the costs of refinancing, which includes “points,” application fees and other expenses that can run up to thousands of dollars.

Costs are then divided by monthly payments to determine how long it will take for savings to outweigh expenses. If the homeowner expects to have the loan longer than that, refinancing appears to be a profitable move.

But two other factors need to be considered. First is how much interest will be paid before the loan is paid off. A homeowner with 15 years left on a 30-year loan can lose money over the long term by refinancing to a new 30-year loan, even if monthly payments are smaller, because interest will be paid for twice as long. On the other hand, if the homeowner expects to sell in 10 years and pay off the loan, the refinancing could make sense.

But that depends on the other key factor: how much of the loan will remain to be paid off when the homeowner sells or refinances again? In many cases, a new loan will chip away at principal more slowly than the old one, leaving a bigger balance to pay off and undermining savings from a reduced monthly payment.

Mortgage and real estate expert Jack M. Guttentag, an emeritus professor at The Wharton School of Business, has a term for many borrowers. “They are payment myopic, which is a pervasive malady among households who never seem to be able to get out of debt,” he writes on his Web site, The Mortgage Professor.

Guttentag offers an example of a homeowner who refinances a 6% loan with 10 years to go and a $200,000 balance. The homeowner replaces it with a 30-year loan at 5.75%, adding $17,000 in closing costs to the loan. The move would slash the borrower’s monthly payment to $1,267 from $2,220. (If that seems like a lot for a relatively small rate cut, it’s because the principal will be paid off over 30 years instead of 10.)

Many borrowers would divide the $17,000 in refinancing costs by the $953 payment cut to conclude that refinancing would pay if the homeowner had the loan longer than 18 months.

A closer look shows that refinancing would not pay if the homeowner kept the new loan for the full 30 years, because total interest would be $238,888 compared to $66,449 with the old loan.

But what if the borrower intended to sell after five years? The lower payment would save her money after the 18-month breakeven period, and total payments over five years would be $75,982 on the new loan versus $133,225 on the old one.

That makes refinancing look good, but there’s a problem: After five years, the balance on the old loan would be down to $114,851, compared to $201,294 with the new loan, a difference of $86,443. By spreading debt payments over 30 years instead of 10, and adding closing costs to the debt, the new loan would whittle the balance much more slowly.

At the end of five years, that extra debt would more than offset the $57,243 saved through lower monthly payments, making the refinancing a money-losing move.

To compare an old loan to a new one, use the Mortgage Loan Calculator. When you look at the old loan, put the current loan balance in the “Mortgage Amount” window, and the approximate years remaining on the loan in the “Term” window.

After putting in the interest rate, click “View Report” to get an amortization schedule that will show what the loan balance would be after any given period. Then do the same with the new loan. Factor the two loan balances into your assessment to figure whether refinancing offers real savings.